When A Total Return Of 15% Beats 107%

|
Includes: AOS, MA, TSCO
by: Steven Miller

Summary

Total Return and Total Return% are important metrics of a stock’s performance, but they do not give a complete picture.

The Total Return% must be assessed for a given period of time to best understand the stock’s performance.

Stocks evaluated by a standard Total Return Ratio can be compared against each other.

A Total Return Ratio is defined and described here.

Investors are typically happy if a stock they own doubles in price, but not all doubles are the same. A stock that doubled in ten years performed only half as well as a stock that doubled in five, and an investor should be only half as happy with it. A stock that gained twenty-five percent in a single year is better both of the others—its one-year gain exceeded the other two, and if it continues at that pace, it will double faster than the others did. Therefore, the total return of a stock needs to be evaluated against the length of time those returns were earned:

  • Total Return% : x number of days

Any time frame could be used in the calculation, but an annualized return of 15% will double in five years. Five years is equal to 1,826 days (365 * 5 plus 1 day for leap year). So a stock that doubles in five years is a stock that doubled in 1,826 days. A stock that doubled in two and a half years did so in 913 days. Using these figures, the two stocks could conceivably be compared side-by-side:

  • 100% Total Return / 1826 days = 0.0005476% average gain per day
  • 100% Total Return / 913 days = 0.0010952% average gain per day

The problem with this is it is easy to miscount the number of decimal places and think that 0.0010952% is a fraction of 0.0005476%, when the opposite is in fact true.

The Total Return Ratio

An easier metric is to look for 100% Total Return in five years. A more specific way to state this is to look for 100% total return in 100% of five years. 100% divided by 100% equals 1.00:

  • 100% Total Return / 100% of 5 years = 1.00

A stock that returns exactly 100% in exactly five years will have a ratio of 1.00.

Suppose instead a stock gained 20% over a single year. One year is 20% of 5 years, and this has the same ratio of 1.00:

  • 20% Total Return / 20% of 5 years = 1.00

Now suppose a stock’s total return for one year was 6%. Using the Total Return Ratio, the stock would score 0.30:

  • 6% Total Return / 20% of 5 years = 0.30

An Example

I opened the position on MasterCard (MA) on June 30 th, 2014 at $74.27. I hold the stock today, and the price per share as of this writing is $151.34.

Chart
MA data by YCharts

The stock has gained $77.08 from my initial cost of $74.27. In addition, each share has paid out $2.50 in dividends since I bought it three years ago. The Total Return (not reinvesting dividends) is 107%. As of this writing, I have held the stock 1,237 days, 68% of 5 years:

  • 1,276 days held / 1,826 days = 70% of 5 years

Using 107% Total Return and 70% of 5 years, the Total Return Ratio for MasterCard is calculated as 1.53:

  • 107% Total Return / 70% of 5 years = 1.53.

MasterCard has far exceeded a Total Return Ratio of 1.00, and I am, of course, quite happy with that result.

Comparing Ratios

Winners such as MasterCard have easy charts to read, but how well are they really doing? Are they doing better compared to my other holdings? Stocks are bought at different times at different prices, and have different dividend rates.

For example, another stock I own is A. O. Smith (AOS). I bought it on August 1st, 2017, less than six months ago, at $54.03.

Chart
AOS data by YCharts

As I write, it sits at $61.98. It has paid a dividend of $0.14/share since I bought it. The Total Return % is 15%, and I have held it for 8% of five years.

  • 15% Total Return / 8% of 5 years = 1.85

As of today, A. O. Smith’s ratio of 1.85 is beating MasterCard’s 1.53. That is partly due to the fact that I caught Smith at a significant dip six months ago. In addition, the Total Return Ratio is more sensitive at shorter periods of time. Just a couple of weeks ago A. O. Smith's ratio was at 2.24, when the stock price set a new high. Give the stock a couple more years, and I expect its ratio will stabilize. But given its business and its growth trajectory, I would not be surprised if its ratio continues to beat MasterCard’s.

So far, I have showed charts from two companies that have been growing for years. They have pretty charts, and I would enjoy showing more like them, but the Total Return Ratio also works well stocks with less stellar charts. For example, take a look at Tractor Supply Company (TSCO) (below). I bought shares of the company in August of 2012 at $47.00. By mid-2016, I had a double within four years. Not long after hitting its high, it dropped and I thought, eh, it’ll come back again. Instead, the floor dropped out from underneath it. The stock price fought its way back, but then dropped even more. Shares of the company dropped to its lowest price in 2016 at $49.87.

Chart
TSCO data by YCharts

I had bought in at $47.00 and I was still in the green. In addition, the stock has been throwing off dividends for the entire time I have owned it, giving me some added cushion. I figured the stock would not go much lower than $50. It soon showed remarkable tenacity when the rest of the market went down. The stock has since vindicated itself somewhat, recovering 50% of its price since its 2016, but I had little idea how well its performing for me, considering my cost basis.

The Total Return Ratio gave me the perspective I needed. Tractor Supply has given me 63% Total Return for 107% of five years, giving the stock a ratio of 0.59. While I would rather have a double in Total Returns, the stock is still performing twice as well as one with a relatively flat stock price (such as a preferred) that yields 6% in dividends.

The ratio cuts both ways, and is not very forgiving to a stock losing money. The ratio for such a stock will have a negative ratio. For instance, I bought Argan (AGX) in November, and it almost immediately lost about a third of its value. My latest position is currently showing a Total Return Ratio of -12.56.

Chart
AGX data by YCharts

A Tool to Take Away with You

The Total Return Ratio is a helpful metric for determining the performance of a stock price. A stock that doubles its Total Return in five years will have a ratio of 1.00, as will a stock achieves a Total Return of 20% in a year. A ratio of 1.00 is a rigorous but achievable benchmark to strive for.

Disclosure: I am/we are long MA, AOS, TSCO, AGX.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.